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21 May 2020

Preventive composition procedure: A valuable tool in a time of economic crisis


COVID-19 has impacted all businesses and economies around the globe with a precipitous decline in demand and supply as a result of quarantine orders, business closures, and social distancing. International Monetary Fund research suggests that the world economy may shrink (in the year 2020) by 3% with the trade volume falling by 11% and the oil prices by 42% (World Economic Outlook, April 2020: The Great Lockdown). In these challenging circumstances and with significant level of debt, many companies are at the onset of insolvency.

In such a corporate environment, restructuring could be seen as a way of life. However, restructuring does not have to be an overwhelming undertaking; and, in fact, it can be quite rewarding for its stakeholders — especially if approached in a methodical way. Companies like General Motors, Chrysler, Marvel Entertainment, American Airlines, etc have all successfully worked their way out of US Chapter 11 bankruptcy proceedings. Undoubtedly, if a financially distressed company could be successfully rehabilitated, all stakeholders (including shareholders, creditors, business partners, and employees) may see a benefit from financial rehabilitation as opposed to filing for bankruptcy. To pursue these objectives, a distressed company based in the UAE may turn to the Federal Decree Law No. 9 of 2016 on Bankruptcy (the “Bankruptcy Law”).

This article is focused on preventive composition procedure, and it is intended to help executives better understand how valuable a tool it can be during a time of crisis by availing themselves of the protections afforded under this procedure. As a general matter, preventive composition procedure allows a company that is facing financial difficulties but is not yet "insolvent" to utilize a court led process to reach a settlement and restructure its obligations and assets.

Key benefits of preventive composition procedure

  • Automatic Stay: if a court accepts an application for preventive composition procedure, all bankruptcy and enforcement proceedings will be automatically stayed unless the court approves any specific proceeding, thus providing the company with a much needed “breathing spell”.
  • Preservation of Business: companies that are operating a business can continue operations during the implementation phase, which means that a business's name, goodwill, and customer base are preserved.
  • Additional Borrowings: upon request of the company or trustee, the court may allow the company to raise priority funding on a secured or unsecured basis to allow the business to continue during the composition process.
  • Set offs: upon implementation of the composition process, no set off may be made by a creditor unless such set off is part of the implementation plan or if otherwise approved by the court.

It is important to note that secured creditors are prioritised under the Bankruptcy Law (unless they have opted to be a part of the composition plan); however, they would be required to obtain court approval to claim (following the approval of the plan) against the trustee regarding their secured assets. The Bankruptcy Law allows secured creditors 20 business days to bring their claims following the court's publication of the decision approving the plan.

Application of the Bankruptcy Law and requirements for preventive composition procedure

The Bankruptcy Law applies to all onshore commercial companies, government-owned companies that have opted-in under the Bankruptcy Law, free zone companies (except those companies incorporated in free zones that have their own insolvency legislation, such as the Dubai International Financial Centre and Abu Dhabi Global Market), traders and licensed civil companies.

Under the Bankruptcy Law, only the debtor company may apply to the court to commence the preventive composition procedure. In addition, when making the application, the company cannot be insolvent under any of the following insolvency tests:

  • Over indebtedness test (balance sheet test): where the assets of the debtor, at any given time, do not cover the liabilities; or
  • Unpaid debt test (cash flow test): where a debtor is deemed to be insolvent upon cessation of payment of statutory debts as they fall due for more than 30 consecutive business days.

Further, preventive composition procedure is not available where either a company has already been subject to such a procedure or has already entered bankruptcy proceedings. Therefore, timing is quite critical and executives should act before the company finds itself meeting any of the insolvency tests outlined above.

Process for preventive composition procedure

The process for requesting preventive composition procedure includes making an application with the court and submitting documentation regarding the financial position of the company and its creditors, assets, debtors and employees; its constitutional documents, license and resolutions; copies of the company's accounting books; the proposals for preventive composition; and a nominated trustee for the procedure. If the application is accepted, the appointed trustee will then take inventory of the company’s assets, compile a list of creditors and corresponding obligations and draft a preventive composition plan together with the company, which should be submitted to the court within 45 days from the date of acceptance of the application. The draft plan requires approval by a majority of the company's creditors entitled to vote, provided that the majority holds at least two thirds of the total debt by value. If the proposed plan is approved by the majority of creditors, it is then submitted to the court for ratification; and if ratified, the plan will be binding upon all unsecured creditors. However, should the court reject the plan, it may either request that the trustee submit an amended plan or otherwise directly commence bankruptcy proceedings under the Bankruptcy Law.

During the implementation period of a plan, the debtor company continues to run the business, but the court-appointed trustee has certain rights to preserve the assets for the company. Any activity affecting the secured creditors must be approved by the court. The plan would end once the company has satisfied all its obligations as per the plan. In the event the company fails to comply with the terms of the plan, the court may nullify the plan and convert the proceeding to liquidate the assets of the company.

How we can help

Preventive composition procedure under the Bankruptcy Law provides a time-bound and transparent process for a distressed company to reach an agreement with its creditors pursuant to a court-supervised plan. Generally “approaching the court for restructuring” is a difficult proposition for people at any level of company, but it also can be seen as a valuable tool for a company that does not necessarily signal the end of the company's business.

With the right restructuring strategy, brands can get back on their feet and emerge from distress stronger than ever. In fact, preventive composition procedures could be a necessary art in the present business environment. To take advantage of this tool, a distressed company should not wait for the insolvency tests to kick in for a formal restructuring or liquidation and may ideally take support of the court driven composition procedures to facilitate their financial rehabilitation. Nonetheless, the decision concerning the use of preventive composition procedures requires careful consideration of the various benefits and burdens imposed upon the business; and therefore, the decision to proceed should be carefully discussed with experienced consultants.

If you would like further information on preventive composition procedure or other options that may be available under the Bankruptcy Law or you need assistance, please get in touch with Nijoe Joseph or Gaurav Jain or your usual contact at Stephenson Harwood.

Please note nothing contained herein is intended to be a legal opinion or a complete statement of the applicable law.

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